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Pricing Trends

VRC’s proprietary research indicates that the range of observed coupon spreads for 1st lien, 2nd lien, and unitranche loans has narrowed since last quarter due to increasing competitive pressures. Accordingly, we decreased the high end of our “fairway” credit spread ranges by 25 bps across the board from 3Q 2023 while maintaining the low end, resulting in a 12.5 bps decline at the midpoint of our ranges:

• 1st lien loans: 4.50% – 5.25%
• 2nd Lien loans: 8.50% – 9.25%
• Unitranche loans: 5.75% – 6.50%

These changes, coupled with similar Spot EURIBOR, the base reference rate considered by VRC’s yield matrix, resulted in lower yields since 3Q 2023.

While competition in the European market increased quarter-over-quarter, market participants note that credit spreads tightened less than in the U.S. Direct Lending market, which saw a decline of ~25 – 50 bps quarter-over-quarter.

Direct lenders report more competition and pressure on credit spreads on deals that traditionally would have gone to the bank market as banks re-enter the market. However, banks are increasingly selective on which deals to underwrite, focusing on deals with short lead times, such as sponsor-to-sponsor deals. There is less appetite for more complicated deals with longer lead times, such as take-privates, deals with long regulatory approval processes, or carveouts. Direct lenders are still winning the lion’s share of these deals.

Deal Volume Trends

Deal flow remains below early 2022 pre-Ukraine invasion levels as market participants note increased uncertainty about the economic outlook and the impact of higher reference rates and credit spreads. As a result, private equity M&A activity slowed considerably, given the mismatch between private equity buyer and seller expectations. However, in the second half of 2023, improvement and clarity around some of these factors improved pipelines for direct lenders. 2023 private equity fundraising was robust, nearing record 2021 levels. Existing portfolio companies continue to be a material source of further investment opportunities for direct lenders as companies continue to execute buy-and-build and other accretive investments.

Deals completed in 2023 are generally viewed as “high-quality” and typically demonstrate some combination of strong growth expectations via organic or acquisitive means, high margin and stable cash flow profile, and modest leverage levels. These factors give the acquirers and lenders confidence in the company’s ability to weather the higher cost of debt and any unexpected deterioration in the economic environment. As a result, these deals continue to command purchase price multiples closer to pre-Ukraine invasion levels and typically forecast improving interest coverage ratios on the back of growth and the lower forecasted reference rate based on the forward EURIBOR curve. Therefore, while lower than the peak, underwritten leverage levels remain aggressive. Direct lenders are willing to underwrite interest coverage ratios, adjusted for capital expenditures, less than the historical lower bounds of 2.0x – 2.5x based on current spot rates; where possible, direct lenders are trying to include interest rate hedges (typically 50% of debt hedged).

Deals considered “lower-quality” are largely not being brought to market as sponsors do not want to risk a failed sale process, work to improve the underlying businesses, or fix any capital structure issues. Sponsors and direct lenders report that any issues with portfolio companies are being proactively managed, and portfolios are holding up relatively well, with performance and liquidity generally better than worse-case scenarios earlier in the year. Most problem areas in portfolios have been known throughout the year with few big surprises. Common capital structure solutions include PIK toggle adjustments, sponsor equity contributions, enhanced liquidity monitoring, and amendments to covenant levels. The overall goal of these adjustments is to position the company better to weather the higher cost of debt from higher reference rates by reducing leverage levels and/or cash interest burden. Direct Lenders typically receive extra economics (PIK premiums, amendment fees, and/or principal repayments) as part of the amendments.

2024 Outlook

Looking forward to 2024, bearing no major shocks, market participants generally expect improving deal flow and an accessible fundraising environment as market participants become increasingly comfortable with the economic environment, the reference rate outlook, and portfolio performance expectations. Market participants hope that the recent pick-up in deal flow and successful executions will encourage a wider swath of borrowers into the market, versus the 2023 market conditions that heavily favored “top-tier” companies.

Market participants also note that approaching maturities in both the Bank and Direct Lending markets will force more borrowers to the table for entire exits, additional fundraising, or refinances. Direct lenders believe they are well positioned to continue to capture share from the Bank market as banks remain limited in their underwriting. Direct lenders can offer competitive pricing, creative structuring, PIK pay options, junior capital, and the certainty of close.

Underwriters will continue to focus on interest coverage and forward expectations to manage risk. If reference rates remain high, there may be further pressure on credit spreads. If either credit spreads or reference rates decline and the market remains competitive, underwritten leverage levels will likely remain on the aggressive end of historical standards. To supplement capital structures where cash interest costs remain high, sponsors will increasingly look to PIK toggle or 100% PIK pay securities to secure the appropriate leverage to meet Private Equity required IRRs and maintain reasonable interest coverage ratios. Direct lenders will likely continue to require high equity cushions providing downside protection, more adequate cash flow coverage levels, and more robust credit agreements that include liquidity or cash flow coverage tests and 50% hedging requirements.

For existing portfolio investments, many market participants expect performance to generally hold up with some potential relief from high cash interest expense as reference rates are largely believed to be at peak levels. While idiosyncratic issues will likely continue, overall default rate expectations remain modest, albeit higher than current levels.

Overall, valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, affordability of debt, and available liquidity. Therefore, some credits will continue to fare better than others.

Q4 2023 VRC European Market Credit Spread Matrix

VRC maintained the low end of pricing ranges and lowered the high end by 25bps for our Middle Market Matrix in December, resulting in 12.5bps lower midpoints. OIDs have stayed steady from 3Q23 at 97-100. Clients note that although new deal volume improved, the availability of lending capital is outstripping supply, thus leading to elevated competition, tighter pricing, and historically aggressive capital structures based on today’s spot rates.

Inflation Rate

Inflation in the United Kingdom increased slightly month-over-month, from 3.9% in November to 4.0% in December 2023. However, inflation is down materially year-over-year from the December 2022 figure of 10.5%.

In December, inflation in the European Union increased to 3.4% from 3.1% in November, although still a significant decline YoY, dropping from 10.4% in December 2022.

Inflation for the Euro Area is slightly higher MoM, from 2.4% in November to 2.9% in December 2023, but down materially from 9.2% at the end of 2022.

Reference Rates

In late 2022, the Bank of England’s Monetary Policy Committee (MPC) and the European Central Bank (ECB) began increasing base lending rates periodically to combat inflation.

Consequently, UK and European reference borrowing rates, SONIA and EURIBOR, rose from late 2022 through August 2023, effectively mirroring MPC and ECB policy increases, before leveling off in November and December when both the MPC and ECB held base rates as inflation continued to trend lower. Like in the U.S., many now believe that inflation is under control.

In their November report, the Bank of England’s MPC left interest rates unchanged at 5.25%. Meanwhile, after ten consecutive rate hikes, the ECB also opted to hold their main deposit facility rate at 4.0% in November and December. The current 4.0% rate is the highest level in the history of the ECB.

Mirroring ECB and MPC base rate increases, 3M EURIBOR increased from 1.17% in September 2022 to 3.91% in December 2023. 3M EURIBOR decreased from 3.95% in 3Q23 to 3.91% in 4Q23. SONIA 3M Compounded increased from 1.55% in September 2022 to 5.22% in December 2023, driving loan yields to historical highs. SONIA 3M Compounded increased from 5.12% in 3Q23 to 5.22% in 4Q23.

According to Bloomberg forecasts, EURIBOR rates will likely peak in Q4 2023 at 4% and are projected to level out in the ~2.75% area long term. SONIA also likely peaked, increasing to 5.22% through December 2023, and is projected to decline to ~3.5% long term. These longer-term rates are down about 100bps since Q3, post stronger inflation, employment, and macroeconomic news. This leads to the expectation that the UK and Euro Union governments will lower base rates sooner and by a greater magnitude.

Secondary STM and YTM

Spread to Maturity for the ELLI Index increased ~22bps Q/Q to 5.02% at 4Q23; Spreads are down ~185 bps from peak spreads in 2Q22. Meanwhile, the ELLI Index YTM of 9.05% at 4Q23 increased from 8.87% at 3Q23. Since 2Q22, the ELLI Index YTM has increased ~240bps, with the rise in reference rates more than offsetting the decline in spreads.

The European B-rated loan index followed a similar trend as the larger ELLI Index, with spreads rising ~7bps from 3Q23 to 4.85% at 4Q23. Meanwhile, Yield to Maturity for B-rated loans held flat quarter-over-quarter at 8.84%, despite volatility early in 4Q23.

European Share of LBOs Financed Via BSL vs. Direct Lending

Direct lenders are outpacing syndicated markets in terms of LBO financing by a ratio of 10:1. Globally, banks are generally pulling out of the riskier deals or borrowers in the lower single B rating category, which includes carve-outs, work-out financings,and generally highly leveraged capital structures.

Leveraged Loan and HY Bond Volumes (€Bn)

LCD reported that European senior loan volume was ~€47.28Bn in 2023, a ~14% decline from 2022 figures.

Private credit continues to be active despite higher base rates and geopolitical risk.

Volumes picked up compared to 2022 but are still below historical averages. Most of the volume coming to market is add-on financing (44.6% per LCD) compared to new deal financing.

LCD is anticipating that refinancing activity will increase in 2024, with 2018/2019 deals coming due and lower expected borrowing rates (spread compression and lower base rates). Private lenders will likely continue to replace bank facilities when maturities come near. M&A activity is also likely to continue to climb, providing more demand for credit.

Broadly Syndicated Credit Statistics (Primary)

Given higher market interest costs from the ~400bps rise in base rates, average leverage ratios declined over 1x on new deals. Meanwhile, average interest coverage declined to ~3.0x from over 4x before the base rate run-up.   Relative to their U.S. counterparts, European deals were underwritten more conservatively better to absorb EBITDA declines and the interest rate shock. Based on VRC data, current average interest coverage levels with U.S. private lending borrowers are ~1.5x  vs ~2.5x in Europe.

Morningstar European LL Index Default Rate

Per Morningstar, average leverage loan default rates have been increasing since early 2023 due to a combination of company cash flows impacted by higher interest costs via higher base rates coupled with selected issues with more cyclical companies impacted by inflation and lower consumer spending.

European Defaults Will Rise on Confluence of Stressors

According to S&P Capital, European speculative-grade corporate defaults will rise to 3.75% (from 3.0% in June 2023) by June 2024 in their base case forecast. They note high interest rates as the leading cause of the forecasted increase. We mention this is ~100bps lower than the expected default rate for U.S. borrowers as the Euro deals were initially more conservatively levered (lower leverage ratios, higher interest coverage, and larger cash/liquidity cushions).

Overall, these levels are still relatively low compared to other higher stressed periods (great Recession, COVID, etc.) and are unlikely to lead to material portfolio losses for managers and investors. Generally, most economists expect a “soft landing” as macro growth is expected to continue and unemployment is expected to remain low.

European PE Deal Activity

Annual 2023 European private equity deal volume of €420.5B is a 26.5% decline over 2022 deal volume, as reported by Pitchbook.

Most volumes are add-on acquisitions to existing PE platform deals, with only a limited volume of the highest quality, Tier 1 deals getting completed (buyers/sellers aligned on valuation and credit financing is available).

The outlook for 2024 is more positive, with large coffers of dry powder and PE pipelines building. Lower expected borrowing costs and improved company valuations will likely tighten the bid-ask spread between buyers and sellers and reinvigorate M&A activity.

European PE Fundraising

According to Pitchbook, European PE funds have raised €117.8B in 2023, just shy of the record $118Bn raised in 2021. PE Fundraising should remain strong in 2024 with improved company fundamentals and an improved exit environment.

European PE Dry Powder (€M)

According to data from CapitalIQ Pro, cumulative dry powder in 2023 for European sponsors is €435Bn, the highest recorded level since 2010, which should fuel deal flow for 2024 and into 2025 without additional fundraising.

These figures also support the continued high demand for private credit. Assuming an average 50% LTV on PE deals, the PE dry powder figures imply an equal demand of €435Bn for credit to finance PE leveraged buyouts.

In addition to higher volumes from new PE LBO deals, lenders may see more opportunities to finance creative PE exits via dividend recaps and net asset value lending in 2024.

European Median EV/EBITDA Multiples

European median PE buyout EV/EBITDA multiples declined in 2023 to 10.2x, dropping 2.0x from 2022 but remaining within historical bands as mostly Tier 1 deals are coming to the market.

Nevertheless, the slower consumer and corporate spending outlook and the much higher cost of borrowing are clearly negatively impacting growth forecasts and valuation multiples.

For 2024, higher public market valuations and lower expected borrowing costs should continue the momentum from Q4 2023 with higher deal volumes and higher valuations.